A beginner’s guide to trend trading

Trend following as a strategy has a long and venerable history. Here’s a guide to how to get started – including how to use three popular trend-following indicators.

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IG Analyst

2017-10-19T15:27:00+0100

Source: Bloomberg

What is trend trading?

Trend trading is a strategy which involves using technical analysis to predict, and take advantage of, market momentum. It’s based on the idea that markets have an element of predictability – and that by analysing charts and identifying previous price patterns, traders can take an educated guess about what could happen in the future.

Trading market trends involves opening a position when you believe an existing trend is going to extend, or a new trend is forming. As the position is kept open for as long as the trade is earning profit, the trend trading can be short, medium or long-term strategy.

Three popular trend indicators

Ascertaining when a trend is about to begin can be difficult, but key patterns can be identified using indicators. Three of the most commonly used indicators for trend trading are:

Trend indicator one: moving averages

Moving averages provide a smoothing effect to the price data, creating a line that can help aid the visual identification of trends. There are popular choices, such as the 50-day and 200-day moving averages, but in reality the choice will depend on the individual, and on the timeframe used.

Like many indicators, moving averages are frequently misunderstood. They are, crucially, lagging indicators, i.e. they move slower than the price. They do not predict the future direction, but rather, tell you what has happened in the past. However, they are very useful, since their direction can help the trader identify whether the market is moving up, down or sideways.

A crossover between two moving averages can signal a change in the price direction, as we can see below in this chart of the Euro Stoxx 50:

Here we can see the blue 50-period moving average cross above the red 200-period; the price then continues to move higher. This can suggest a trader should move from shorting the market (when the quicker moving average is below the slower one) to buying it (when the quicker is above the slower).

It is important to note that the crossover reflects what has already happened, and we could see a retracement before another move higher. Thus, careful risk management is called for. It is also important to bear in mind that the shorter the periods of moving averages used, say for example 10- and 20-period, rather than 100- and 200-period, will give more frequent crossovers that may be quickly reversed, leading to a run of losses.

However, as a basic tool, moving averages can help to keep a trader on the right side of the trend.

Trend indicator two: relative strength index

The RSI is perhaps one of the most incorrectly-used indicators; when the indicator moves above 70, it is said to be ‘overbought’, and when below 30, ‘oversold’. This is used by commentators as a reason why prices should move back down, or back up again, after significant moves in one specific direction.

Yet, these overbought and oversold conditions indicate trend strength, not an impending reversal. The oscillator can only go so high, whereas prices can move up or down for greatly extended periods. The chart of the Dow Jones shows this:

Here, the price is overbought for a number of consecutive sessions, yet it does not stop rallying. Indeed, even the moves back below the 70 level (signifying dropping out of overbought conditions) do not prompt significant falls in the price. This is an uptrend, and an RSI reading above 50 shows that buyers are in control. Conversely, a reading below 50 in a downtrend shows the sellers have the upper hand.

What the RSI is useful for is identifying retracements in a trend, i.e. pullbacks on the way up, and rallies on the way down. This can, potentially, be used to highlight areas where new positions can be entered, or existing ones added to. In the USD/JPY chart below, the circled areas indicate retracements in the downtrend that a trader can use to identify entry points:

Trend indicator three: average directional index

The average directional index (ADX) helps to identify the strength of a trend. Traders want to find the strongest trends, hop on board, and then ride them as long as possible.

ADX is a single line with values from 0 to 100. It is usually plotted in the same window as the directional movement index (DMI), from which the ADX is derived. Values from 25 to 100 indicate a strong trend, with the strength increasing the higher the number. A value below 25 indicates drift.

It is very important to note that the direction of the ADX does not follow the price. Thus ADX can rise when the price is falling, which is therefore an indication of a strengthening downtrend. An example for the DAX is seen below:

The ADX in the bottom panel drifts down during summer, but then in mid-September it rises above 25, indicating a strong rally that does indeed continue. It does not work all the time, as the rally from February to April when the ADX remains below 25 shows.

The above indicators are not foolproof, crystal-ball methods of finding and catching every trend. But they can be used to filter out markets that are not trending, or are trending weakly.

How to start trend trading

Learning to analyse market trends is just one part of a successful trend trading strategy. Without proper preparation and risk management, even the best trading strategy won’t make you money in the long run. Here are a three steps to help get you started trend trading:

Trend trading step one: choose a market

When opening a position, it’s important to first have an idea of what you want to trade. While some trend traders might choose to focus on one specific market, others diversify their opportunities by spreading their positions over a range of markets – gaining exposure to more trends.

Once you’ve decided what you want to trade, you’ll need to continue to keep up to date with any developments that could drive new trends, or cause countertrends. These might include breaking news, central bank policy announcements and political events.

Trend trading step two: implement a risk management strategy

Managing your risk is a crucial aspect of trend trading, and knowing when to exit a trade is just as important as knowing when to enter one. A common practice for trend traders is to attach a stop-loss to a position in order to minimise losses if the trend ends, and the market reverses.

Sometimes you might get stopped out of a profitable trade only to watch the trend continue. Early exits can be frustrating, but it’s important to stick to your strategy and not let emotions get the better of you.

Trend trading step three: start trading trends

While the above indicators are a useful tool for finding trending markets, and likely patterns, predicting the exact movements of a market is near impossible. Trend trading is not about finding the absolute beginning of a trend, just identifying the trend early enough to profit from the main body of the market momentum.

The best way to learn about trend trading, and using trend indicators, is to try them out for yourself and see which strategy works best for you. You can develop your trend trading strategy and practice using indicators in a risk-free environment with an IG demo trading account. Or if you feel confident enough to start trading on live markets, you can open an account with IG in minutes.

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